Download Article: As a result of the housing collapse, many Americans have seen their homes lose half their value,[1] owe several hundred thousand dollars more on their homes than their homes are worth,[2] and are unlikely to climb out of this hole for dec*ades.[3] For these individuals, the American dream of homeownership has become a nightmare, and their financial future is dim.
To compound their stress and anxiety, when they’ve called their lenders to work out a solution, they’ve discovered that their lenders won’t even discuss the possibility of a loan modification or a short sale so long as they are current on their mortgages.[4]
Out of desperation, some of these underwater homeowners have decided that they’d be better off letting go of their homes and have thus intentionally stopped paying their mortgage.[5] Many have done so with the hope that def*aulting on their mortgage will finally bring their lender to the table, but also resigned to the fact that they will likely lose their home.
In a recent article, economist Luigi Zingales suggests that these homeow*ners are immoral.[6] He also criticizes me, along with Roger Lowenstein of the New York Times, for supposedly contributing to the social menace of strategic default.[7] Others have joined Zingales in his condemnation of underwater homeow*n*ers who strategically default.[8]
Before responding to these critics, it is important to emphasize that the decision to strategically default on a mortgage involves many complex, localized, and individualized factors.[9] No one should decide to strategically default on their mortgage without sitting down first with a knowledgeable professional to discuss in detail the best course of action.[10] For that reason, I’ve never advised underwater homeowners as a group to strategically default on their mortgages, and I am not doing so here.
But let’s say that an underwater homeowner has actually sat down with a professional to do the calculations and has concluded that defaulting on his mort*gage is the only way out of his financial nightmare. Would it be immoral or irresponsible for him to do so?
The argument against homeowners intentionally defaulting on their mort*ga*ges generally centers on the same three basic points. First, underwater homeow*ners promised to pay their mortgages when they signed the mortgage contract, and it would be immoral to break this promise.[11] Second, foreclo*sures lead to depreciation of neighborhoods, so underwater homeowners should hang on in order to help preserve their neighbors’ property values.[12] And, third, if all underwater homeowners defaulted, the housing market might crash.[13] Homeowners thus have a social obligation to pay their underwater mortgage in order to save the economy.
While all three of these arguments might have some initial appeal, none of them hold water.
First, a mortgage contract, like all other contracts, is purely a legal docu*ment, not a sacred promise.[14]
Think of it this way: When you got your cell phone, you likely signed a contract with your carrier in which you promised to pay a set monthly payment for two years. Let’s say, though, that two months after you sign your contract, the price of cell phone service drops by half—meaning that the same cell phone service for which you pay $100 a month could be had for $50 with another carrier. You decide that you would be financially better off paying the early termination fee of $300 rather than $100 a month for twenty-two more months of the same service that you can now get for $50.
Would it be immoral for you to break your contractual promise to pay $100 for two years and elect instead to pay the early termination fee? Of course not. The option to breach your promise to pay is part of the contract, as is the con*sequence of breach—a $300 early termination fee. There is absolutely noth*ing immoral about exercising your option to breach, and you’d be financially wise to do so.
Though a mortgage contract is more substantial than a cell phone cont*ract, it’s no different in principle. Like a cell phone contract, a mortgage contract explicitly sets out the consequences of breach.
In other words, the lender has contemplated in advance that the mort*gagor might be unable or unwilling to continue making payments on his mortgage at some point—and has decided in advance what fair compensation would be. The lender then wrote that compensation into the contract. Spe*cifically, the lender probably included clauses in the contract providing that the lender may foreclose on the property, keep any payments previously made on the property, and may opt to pursue a deficiency judgment against the mortgagor if state law so allows.[15]
By writing this penalty into the contract and then signing the contract, the lender has agreed to accept the property and (in most states) the option to pursue a deficiency judgment in lieu of payment. Of course, even in states where they can, lenders frequently don’t pursue borrowers for deficiency judgments because it’s often not economically worthwhile to do so.[16] Nevertheless, that’s the agreement. No one forced the lender to sign—or write—the con*tract,[17] and the lender wouldn’t hesitate to exercise the right to take a defaulter’s house if it were financially advantageous to do so. Concerns of morality or social responsi*bil*ity wouldn’t be part of the equation.[18]
In short, as far as the law is concerned, choosing to exercise the default option in a mortgage contract is no more immoral than choosing to cancel a cell phone contract. The borrower must simply be willing to accept the conse*quences, which, in the case of a mortgage contract, typically include foreclosure and the risk of a deficiency judgment in most states.
Even though the law doesn’t treat breach of a mortgage contract as a moral wrong, it might be argued that one should still keep one’s promises.[19] That’s a fine belief as far as it goes.
But why treat the promise to pay one’s mortgage as any more sacred than any other promise? We break promises all the time when the consequences of fulfilling them become too great—without being considered immoral for doing so.[20] I recently promised my daughter, for example, that I’d pick her up early from preschool. Though I take promises to my children seriously, I had to break this one because an important meeting ran long at work. I had competing obligations and had to make a choice. Though some might quibble with my choice, it wasn’t immoral.
In short, it’s simplistic to suggest that it’s always immoral to break a pro*mise. A more accurate description of the social norm is that one should keep one’s promises unless one has a compelling enough reason not to do so.[21] For example, needing to move in order to take care of a seriously ill family member would be a good reason, at least in most people’s estimation, for a renter to break a lease agreement. The renter would still have to face the risk that the landlord might pursue the remainder of the lease payments, but few would think the renter immoral for taking that risk. Indeed, not only is breaking a promise frequently acceptable, sometimes it’s the most moral thing to do.
This is no less true for a mortgage contract.
For many Americans, their home is their primary, and perhaps only, inves*tment.[22] With encouragement from the government and the financial industry, most Americans came to see investing in a home as the primary route to reti*rement security, as well as a means of sending their children to college.[23] With the housing bust, however, many Americans’ hope of using the accumu*lated equity in their homes to support themselves during retirement, or to pay for their children’s college, has vanished.
Moreover, because housing prices were so high during the boom, many Americans were forced to stretch to buy even modest homes—meaning that all or most of their disposable income now goes to their mortgage, with little left for savings.[24] Pouring all of their disposable income into their homes might have worked out for most people if housing prices had continued to increase, or at least stayed stable.
But despite the forecasts of many of the world’s top economists,[25] they didn’t. As a result of a housing collapse unprecedented in its severity,[26] many underwater homeowners now find themselves pouring all or most of their dispos*able income into a home that is no longer an investment, but rather a threat to their families’ financial security. For many Americans, paying the mortgage means little to no savings for retirement or to send their children to college.
The moral course in such a case may, in fact, be to stop paying one’s mort*gage, even if one can afford it according to some arbitrary debt-to-income ratio established by the banking industry.[27] It might be more responsible to rent and put the money saved from giving up one’s home into a retirement acc*ount, so that one is not a financial burden on others in old age, or into a college fund, so that one can give one’s children chance at higher education.[28]
In other words, things aren’t so black-and-white. And given the unpre*cedented nature of the housing collapse, it should at least be possible for reasonable people to disagree about the most moral or responsible course of action for seriously underwater homeowners.
I personally believe that one’s promise to pay the mortgage should som*etimes give way to the more important obligation to provide for one’s family—especially when the lender specifically contemplated the possibility of default in the mortgage contract.
But what about the argument that mortgage default hurts neighborhoods and the economy?[29]
As an initial matter, we don’t typically expect individuals to make personal economic decisions for the good of the “generalized other” in a capitalist soci*ety.[30] Aside from this fact, however, it’s a lot to ask of underwater homeowners to prop up neighborhood property values or the housing market on their backs—especially if it means sacrificing their own financial security. In my view, it’s also an unfair burden.
If we are to go down this collective path, however, why are only homeow*ners, and not financial institutions, called upon to sacrifice their own economic well-being for the common good?[31]
As their own behavior has evidenced by now, lenders generally modify mortgages for underwater homeowners only when it’s in the lender’s financial interest to do so.[32] From the lender’s perspective, modifying a mortgage for a homeowner who is still making payments on time is potentially throwing money away because the homeowner might still make the payments even without a loan modification.[33] This is why underwater homeowners typically have to default on their mortgages before lenders will even talk to them.[34] Unfortuna*tely, once a homeowner initially defaults, a home is statistically much more likely to end up in foreclosure.[35]
Why take homeowners, and not lenders, to task for putting their own financial interest ahead of the common good?
If lenders were less intransigent and more willing to negotiate, underwater homeowners wouldn’t have to walk away from their homes in order to save themselves from financial ruin.[36] In turn, we wouldn’t have to worry about the fragile housing market crashing once again.
Why also speak of morality and social responsibility only when talking about strategic default by homeowners and not by financial institutions or large corporations?[37]
In the biggest real estate default in history, for example, real estate giant Tishman Speyer Properties strategically defaulted on $4.4 billion in loans on New York’s Stuyvesant Town and Peter Cooper Village after the properties lost $2 billion in value—despite having billions in assets, including Manhattan’s Rockefeller Center and the Chrysler Building, that it could have leveraged to meet its obligations under the loans.[38] Morgan Stanley did the same on a $1.5 billion mortgage on five buildings in San Francisco when the buildings lost half their value, despite raking in record profits the same year.[39] Neither entity was criticized for being immoral.[40] Apparently, what is good for Morgan Stanley or Tishman Speyer is good for the market.
Some have attempted to justify this double standard by arguing that comm*er*cial mortgage contracts are fundamentally different from residential mortgage contracts.[41] These commentators suggest that parties to commercial mort*gage contracts contemplate the possibility of default in advance and agree on the remedy—typically, surrender of the property. They argue that parties to residential mortgages, on the other hand, contemplate only that the mortgage will be repaid—and thus residential mortgage contracts contain an implicit pro*mise to pay regardless of market conditions that is absent from commercial mortgage contracts.[42]
This argument is thin, at best. Residential mortgage contracts, just like commercial mortgage contracts, contemplate the possibility of default and contain an agreed-upon remedy. It’s true that sophisticated commercial parties frequently negotiate more favorable terms than the average homeowner, includ*ing provisions that sometimes more strictly limit the lender’s recourse in the event of default.[43] But this is not a moral difference, and it does not change the fact that both types of contracts contain agreed-upon remedies in the event of default. Indeed, if anything, the difference between commercial and resi*dential mortgage contracts cuts in the other direction—and we should be more forgiving of less sophisticated residential borrowers. It just can’t be the case that it’s morally acceptable for financial institutions and large corpo*rations to default on their mortgages, as long as they are willing to bear the contrac*tually agreed-upon penalty in their contract, but it’s not okay for average Americans to do exactly the same thing. There shouldn’t be two sets of rules.
I would favor a world in which all actors—both corporate and individual—acted or were required to act in socially responsible ways. Institutional lenders, which bear a much greater share of the blame for the housing crisis than the average underwater homeowner, would then take responsibility for their actions by writing down at least part of the principal on underwater mortgages.[44]
It would be naïve, however, to wait for this to happen. There’s no indica*tion that financial institutions are going to start voluntarily writing down mortgages for underwater homeowners,[45] nor is there any indication that Congress will ever pass a law requiring them to do so. As long as Congress is unwilling to force lenders to write down underwater mortgages, many homeow*ners will conclude that strategic default is not only morally acceptable, but also the most rational course of action.[46]